July 12, 2013

On July 10, 2013 the SEC approved a proposal intended to enhance its ability to assess developments in the private placement market now that
the final (see foregoing article in this blog) to lift the ban on general solicitation has been adopted. In
particular, the proposal is intended to improve the SEC's ability to evaluate the
development of market practices in Rule 506 offerings and to address concerns raised by investors related to issuers engaging in
general solicitation.

The proposal requires issuers to file an advance notice of sale 15 days before and at the conclusion of an offering…

Currently, an issuer - such as a company or a fund - selling
securities using Rule 506 is required to file a Form D no later than 15
calendar days after the first sale of securities in an offering. That
form is a type of notice that provides information about the issuer and
the securities offering.

Under the proposal, issuers that intend to engage in general
solicitation as part of a Rule 506 offering would, in addition to the
current requirements, be required to file the Form D at least 15
calendar days before engaging in general solicitation for the offering.
Also, within 30 days of completing an offering, issuers would be
required to update the information contained in the Form D and indicate
that the offering has ended.

The proposal requires issuers to provide additional information about the issuer and the offering…

Currently, Form D requires identifying information about the
company or the fund selling the securities, any related persons, the
exemption the issuer is relying on to conduct the offering, and certain
other factual information about the issuer and the offering.

Under the proposal, issuers are required to provide additional
information to enable the SEC to gather more information on the changes
to the Rule 506 market that could occur now that the general
solicitation ban has been lifted.

The additional information would include:

Identification of the issuer's website.

Expanded information on the issuer.

The offered securities.

The types of investors in the offering.

The use of proceeds from the offering.

Information on the types of general solicitation used.

The methods used to verify the accredited investor status of investors.

The proposal disqualifies issuers who fail to file Form D…

Under the proposal, an issuer is disqualified from using the
Rule 506 exemption in any new offering if the issuer or its affiliates
did not comply with the Form D filing requirements in a Rule 506
offering. As proposed, the disqualification would continue for one year
beginning after the required Form D filings are made. Issuers would be
able to rely on a cure period for a late Form D filing and, in certain
circumstances, could request a waiver from the staff.

The proposal requires issuers to include legends and disclosures in written general solicitation materials…

Under the proposal, issuers are required to include certain
legends or cautionary statements in any written general solicitation
materials used in a Rule 506 offering.

The legends would be intended to inform potential investors that the
offering is limited to accredited investors and that certain potential
risks may be associated with such offerings.

In addition, if the issuer is a private fund and includes information about past performance in
its written general solicitation materials, it would be required to
provide additional information in the materials to highlight the
limitations on the usefulness of this type of information. The issuer
also would need to highlight the difficulty of comparing this
information with past performance information of other funds.

The proposal also requests public comment on whether other manner and
content restrictions should apply to written general solicitation
materials used by private funds.

The proposal requires issuers to submit written general solicitation materials to the SEC…

Under the proposal, issuers are required to submit written
general solicitation materials to the Commission through an intake page
on the SEC website. Materials submitted in this manner would not be
available to the general public. As proposed, this requirement would be
temporary, expiring after two years.

The proposal extends guidance about misleading statements to private funds…

Currently, an SEC rule provides guidance on when information
in sales literature by an investment company registered with the SEC
could be fraudulent or misleading for purposes of the federal securities
laws.

Under the proposal, this guidance - contained in Rule 156 under the
Securities Act - would be extended to the sales literature of private
funds. It would apply to all private funds whether or not they are
engaged in general solicitation activities. In the proposing release,
the SEC would express its view that private funds should now begin
considering the principles underlying Rule 156.

Nothing is this blog is intended to be or may be relied upon as
specific legal advice. Securities and related laws are
complex and facts are different from case to case. Competent
counsel should be consulted. Views expressed by the author
in this article are his own and not those of any other
person.

The final Rule (click on "Rule" for full text of the SEC Release on the final rule) approved by the SEC this week makes changes to Rule 506 to permit
issuers to use general solicitation and general advertising to offer
their securities provided that:

The issuer takes reasonable steps to verify that the investors are accredited investors.

All purchasers of the securities fall within one of the categories
of persons who are accredited investors under an existing rule (Rule 501
of Regulation D) or the issuer reasonably believes that the investors
fall within one of the categories at the time of the sale of the
securities.

Under existing Rule 501, a person qualifies as an accredited investor if he or she has either:

An individual net worth or joint net worth with a spouse that
exceeds $1 million at the time of the purchase, excluding the value (and
any related indebtedness) of a primary residence.

An individual annual income that exceeded $200,000 in each of the
two most recent years or a joint annual income with a spouse exceeding
$300,000 for those years, and a reasonable expectation of the same
income level in the current year.

The determination of the reasonableness of the steps taken to verify
an accredited investor is an objective assessment by an issuer. An
issuer is required to consider the facts and circumstances of each
purchaser and the transaction. Nevertheless, in response to commenters'
requests, the final rule provides a non-exclusive list of methods that
issuers may use to satisfy the verification requirement for individual
investors.

The methods described in the final rule include the following:

Reviewing copies of any IRS form that reports the income of the
purchaser and obtaining a written representation that the purchaser will
likely continue to earn the necessary income in the current year.

Receiving a written confirmation from a registered broker-dealer,
SEC-registered investment adviser, licensed attorney, or certified
public accountant that such entity or person has taken reasonable steps
to verify the purchaser's accredited status.

The existing provisions of Rule 506 as a separate exemption are not
affected by the final rule. Issuers conducting Rule 506 offerings
without the use of general solicitation or general advertising can
continue to conduct securities offerings in the same manner and aren't
subject to the new verification rule.

Rule 144A

Under the final rule, securities sold pursuant to Rule 144A can be
offered to persons other than Qualified Institution Buyers ("QIBs"), including by means of general
solicitation, provided that the securities are sold only to persons whom
the seller and any person acting on behalf of the seller reasonably
believe to be QIBs.

Form D

The final rule amends Form D, which is the notice that issuers must
file with the SEC when they sell securities under Regulation D. The
revised form adds a separate box for issuers to check if they are
claiming the new Rule 506 exemption that would permit general
solicitation or general advertising.

No Effect on Exclusions from the 1940 U.S. Investment Company Act Registration

Private funds typically rely on either the so-called Section 3(c)(1) 100 or fewer investors or the Section 3(c)(7) all "qualifed purchasers" exemption from being required to register as investment companies under the 1940 U.S. Investment Company Act. However, there is also a requrement under each of the exemptions that the fund is not making and does not propose to make a "public offering" of its securities. Fortunately the law enabling the final rule made it clear that Rule 506 offerings will not be deemed "public offerings" under the Federal securities laws as a result of general advertising or general solicitation. The SEC reaffirmed this law in its Release discussing the final rule.

What's Next

The rule amendments become effective 60 days after publication in the Federal Register. It remains to be seen how the industry will implement the new rules.

Nothing is this blog is intended to be or may be relied upon as
specific legal advice. Securities and related laws are
complex and facts are different from case to case. Competent
counsel should be consulted. Views expressed by the author
in this article are his own and not those of any other
person.

March 28, 2012

Classically, under Section 4(2) of the U.S. Securities Act of 1933, securities offered and sold by an issuer in a manner not involving any public offering have been exempt from federal securities registration. The SEC in Regulation D has long spelled out a number of "safe harbors" that would guarantee an issuer who complied with the requirements thereof an exemption under Section 4(2). However, consonant with the wording of Section 4(2) these Regulation D safe harbors, with the extremely limited exception of Rule 504 offerings of $1 Million or less that were state law registered or which state law permitted to be sold to only accredited investors via public means, all probibited the use of general solicatations and offerings to the public at large.

Probably the most used Reglation D safe harbor was Rule 506 which allowed the offering and sale of a security in an unlimited amount of capital sought to be raised to up to 35 non-accredited investors and to an unlimited number of accredited investors - although for reasons of other securities laws the ceiling on investors was often 99 or at most 499. Again, consonant with Section 4(2) public means could not be used to conduct the offering.

However, under the recently passed, and soon to be signed, JOBS Act the prohibition on general advertising and general solicitation is gone for Rule 506 offerings. As long as a Rule 506 offering is sold only to “accredited investors” (within the meaning of Regulation D), general advertising will be permitted for all issuers (including hedge funds, private equity funds and special purpose entities), after a 90-day period during which the SEC is to issue implementing rules. Apparently, although it is not 100% clear in the absence of the SEC Rulemaking, the offer itself can be pitched to persons who are not in fact "accredited" investors - such persons merely cannot be sold the securities being offered.

This harkens up visions of at least late night TV ads offering insomniacs all sorts of investment opportunities in unregistered securities. Of course, the Internet will be another logical place for promoters to hawk their securities wares to the public at large. Will more money be lost to "get rich quick" scamsters than will be gained in jobs created by what is, in effect, a new way to do an IPO? Hard to say.

Apart from the outcry, perhaps justifed, that consumer protection types are likely to raise, this is a rather odd, if not unprecedented, way that Congress has done things. One would have logically (if not politically) expected an amendment to Section 4(2) itself that excepted out the no public offering language under certain circumstances equivalent to those in the mandate to the SEC to change Rule 506.Technically, it would seem that the mandated rule change to Section 4(2) is at least arguably at odds with Section 4(2) and surely has eviscerated it to being quite close to a dead letter. However, given that Congress could clearly have changed Section 4(2) itself, and the somewhat tiny crack opened by old Rule 504 regarding the very limited use of public means to make an offering under Rule 504 of Regulation D, this might be of no legal import.

What will be most interesting and will flesh this legal curiosity out a bit more, will be to see what the SEC does by way of rule making for the "new" Rule 506 under the JOBS Act. In the meantime, to those offerors who seek to utilize this new bit of legal legerdemain, the key will be to await the SEC rule making. Gun jumpers beware.

Unlike in the 1913 poem "Sacred Emily" by Gertrude Stein, in law, a rose is often not a rose is a rose is a rose.

November 18, 2011

Margin means a person borrows money from the person's broker to purchase securities.

Buying with borrowed money can be extremely risky because both gains and losses are amplified. That is, while the potential for greater profit exists, this comes at price - the potential for greater losses. However, properly used, margin can be a very valuable tool in the arsenal of a sophisticated investor.

Margin is not static. Margin is based on an investor's equity in a position. So as a position moves against an investor the amount of capital the investor must have available in the account to meet the margin requirement increases. Conversely, as a position moves in favor of an investor, capital the investor has available in the account to meet the margin requirement increases freeing it for investment in other positions.

Margin Example 1 - Decrease in Value

Assuming a 50% margin (this is not the rate for ETF's) a person would have $50,000 equity and $50,000 debit in a $100,000 long position. If the value of the position declined to $90,000 the person's equity would be only $40,000 and the person would have to put up, or have available in the account, an additional $5,000 to maintain the position. This is essentially known as a margin call. If this margin call was not timely met then the broker would sell from the position to the extent needed to raise the additional $5,000.

Margin Example 2 - Increase in Value

Assume the same facts except the value of the position increases to $110,000. Now the person has $60,000 of equity which is $5,000 in excess of what the person needs to maintain the position. The $5,000 excess is available to invest in other positions.

Interest on Margin Accounts

In addition, the broker will charge interest on the debit amount in a margin account. At the date of posting of this article starting effective margin rates on smaller retail debit balances were around 8.5% to 9%,

Part II - ETF Margin Requirements (Basic)

ETFs are typically registered unit investment trusts (UITs) or open-end investment companies whose shares represent an interest in a portfolio of securities that track an underlying benchmark or index. However, some ETFs that invest in commodities, currencies, or commodity—or currency—based instruments are not registered as investment companies. Unlike traditional UITs or mutual funds, shares of ETFs typically trade throughout the day on an exchange at prices established by the market.

A few years ago margin calculation for most ETF positions in margin accounts was straightforward: 25% maintenance margin requirement on long ETF's and 30% on short ETF's was the standard.

However, effective December 1, 2009, on leveraged ETF's, the calculation became more complex.

Because ETF leverage means 2 times or 3 times the move of the underlying, the margin on leverged ETF is now (since 2009) based on the degree of leverage. The maintenance level of 25% for longs grows by the 2x or 3x mutiples. The same for shorts except the "base" level is 30%. Nonetheless, the margin requirement will not exceed 100% of the value of the ETF in any circumstances.

Here are the current rules:

2x LongIf a person buys shares of a 2x ETF on margin, the old maintenance requirement was 25%. Under current rules, this went up to 50%, or twice the old level (25% x 2).

The action increasing the margin requirement, was a response to the greater exposure associated with leverage. The Financial Industry Regulatory Authority (FINRA) explained, "FINRA believes higher margin levels are necessary.”

The FINRA rules also deal with margins on options on leveraged ETF's as well as the impact of leveraged ET's on day trading power of an account.

Part III - Margin on Options on ETF's

FINRA also increased the maintenance margin requirements for listed and over-the- counter uncovered options on leveraged ETFs in a similar fashion. Prior to December 1, 2009, the maintenancemargin requirement for a listed, uncovered option overlying an ETF on a broad-based index or benchmark was:

100% of the option premium;

plus 15% of the ETF market value;

minus any out-of-the-money amount;

subject to a minimumrequirement of:

100% of the option premiumplus 10% of the ETF market value for call options; and

100% of the option premiumplus 10% of the exercise amount for put options.

For a listed, uncovered option overlying an ETF on a narrow-based index or benchmark,the percentage of the ETF market value was 20%.

For a listed, uncovered option on a leveraged ETF, the formula above continued toapply; however, the percentages of the underlying ETFmarket value were to be determinedusing the same methodology as the underlying ETF. Thus, instead of using 15% of theETF market value for a broad-based ETF and 20% for a narrow-based ETF, a leveragedETF at 200% had to and has to now use 30% (two times 15%,or 40% for narrow-based) of the marketvalue, and a leveraged ETF at 300% had to and has to now use 45% (three times 15%, or 60% fornarrow-based).

Part IV - Efect of Leveraged ETF's on Day Trading Buying Power

For day-trading purposes, the calculations to determine day-trading buying powerand day-trade calls also became based on the amount of leverage on the ETF with effect at December 1, 2009. Thus, the day-trading buying power on a leveraged ETF needed to and need to include the higher margin requirements described above.

The following example should help demonstrate the calculation of day-trading buyingpower as it relates to a leveraged ETF: Customer A has a total, long market value, based on the previous nights’ close of business, of $100,000. The market value is composed entirely of long positions in a 300% leveraged ETF. The customer is carrying a margin debit balance of $20,000. The day-trading buying power is computed as follows:

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

September 15, 2011

THE FOLLOWING ARTICLE WAS CONTRIBUTED BY MY GOOD FRIEND AND COLLEAGUE AMIT CHHABRA

The Dodd-Frank Wall Street Reform and Consumer Protection Act continues to pose uncertainty and documentation challenges for derivatives end-user with little clarity in sight. Currently, we can expect much of Dodd-Frank to become effective within 60 days of final regulatory approval, and no later than December 31, 2011.

Some of the more pressing concerns include, but are not limited to, the following:

1. Under the current plan, dealers still need to notify uncleared swaps counter-parties of their right to have collateral held in a segregated account with an independent third-party custodian. The CFTC did not issue a no-action letter with respect to certain municipal entities and individuals prior to the July 16 deadline, so that concern has already been phased in. The International Swaps Dealers Association (ISDA) did not produce a protocol to ease compliance with the notice requirement, so end-users should not rely on that happening in the future either.

2. As in the futures context, dealers will need to have a custodian relationship in place for customer funds. Collateral teams will need to work with custodians and end-users to have these functional by the time this requirement kicks in. Moreover, the industry continues to await further clarity about which party - the dealer or the end-user - has the power to decide which third-party custodian may hold funds.

3. End-users and dealers need to ensure that Credit Support Annexes are in place or amended for uncleared swaps, and Wall Street still need clarity on which of these trades (if any) would be “grandfathered” under pre-Dodd Frank rules.

4. Dealers need to determine which US entity should enter uncleared swap trades and securities-based swap (SBS) trades, in light of proposed margin and capital requirements.

5. Futures contracts require a separate customer pooled account for foreign and domestic customers. Questions abound as to whether US futures commission merchants (FCMs) should clear for foreign customers and the form such an agreement might take, as well as what role these entities should play where a non-US clearinghouse does not even mandate that the broker be registered as an FCM.

6. End-users need to work with their dealers to determine how they can fund their accounts for routine debits, whether margin financing will be offered, and what form such an agreement would take, i.e., how to link the security interest under the margin financing with the OTC and cleared exposure. Where does the futures security interest fit into this picture?

7. We can expect securities-based swaps to be regulated like securities. For cleared SBS, we should expect to see specific requirements pertaining to the handling of collateral.

8. The playing field for these undertakings will be leveled, with custom-tailored negotiation guidelines required by end-users. These must account for the customer clearing relationship, the concerns of the execution agreement that ISDA/FIA have proposed, and relationships undertaken in the name of affiliates.

9. A few recent developments: The CFTC has published final whistleblower rules, though there is concern that the SEC’s rules undermine efforts to protect employees that wish to expose fraud. The CFTC does not consider it appropriate for an employee to report misconduct internally.

Additionally, CFTC Chair Gary Gensler has indicated that in September he will look at clarifying the proposed swap phase-in rules, position limits, clearinghouse core principles, business conduct and entity definitions, trading, data reporting, and end-user exemptions.

Much more needs to be monitored and many open questions remain that only final rules can be expected to answer.

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

The essence of the legislation would be to create a special self regulatory organization (SRO) strictly for investment advisers. Apparently, the theory is that the SEC and the state regulators don't have the resources to adequately oversee the industry.

The idea is that the investment advisers, instead of the taxpayers, will foot the bill for their own regulation and oversight.

The current draft of the bill would exclude the following from oversight by a “registered national investment adviser association”:

Investment companies (mutual fund advisors)

Non-U.S. persons

Clients that in aggregate own at least $25 million in investments

Various religious, education or charitable entities

Stock pension plans and collective trusts

Private equity funds

Venture capital fund

As you can imagine the bill has produced some strong reactions from the industry. Stay tuned.

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

July 11, 2011

The mine-run of mid-sized ($25 Million to $100 Million in Assets Under Management) SEC registered investment advisers will not be permitted to maintain SEC registration when Dodd-Frank is fully implemented. Rather they will be subject to state registration.

However, recent SEC interpretive guidance on mid-sized adviser registration provdes that a mid-sized adviser with its principal office and place of business in New York is not “subject to examination” by the state securities authority (the NY Attorney General's Office) and, accordingly, would continue to have to be registered with the SEC.

Apperently this position came about because in response to an SEC survey, regulators in Minnesota, New York and Wyoming did not advise the SEC staff that advisers registered with them are subject to examination; therefore, mid-sized advisers in these states were to continue to register with the SEC. Minnesota has since reported an examination requirement so New York and Wyoming remain the only states where mid-sized investment advisers will remain required to be SEC registered.

Based on recent figures, this will affect almost 300 mid-sized investment advisers in New York. The figures showed only 1 Wyoming mid-sized investment adviser.

I did get oral confirmation, from a spokesperson from the New York Attorney General's Office, that New York does not in fact have compliance examinations, at least regular ones, of its registered investment advisers. The individual I spoke to could not comment on whether this would change in the future.

It would seem the outlook in New York is cloudy but that for the time being mid-sized NY based investment advisers will be SEC registered and not NY registered.

Finally, even the use of the word "examination" is a little tricky. Many states including NY have examination requirements in the sense that indviduals affiliated with investment advisers need to have taken and passed qualifying examinations to demonstate competence to act as investment advisers. However, what the SEC is referring is an actual compliance "examinations" to ascertain that an investment adviser is operating in compliance with applicable laws and regulationg governing registered investment advisers.

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

April 15, 2011

MId-sized investment advisors (advisors with between $25 million and $100 million in assets under mangagement) will be required to withdraw from SEC registration and become state registered. In view of this, all advisers registered with the SEC as of July 21, 2011 were going to be required to report their eligibility for SEC registration by August 20, 2011. In turn, advisers who reported mid-sized adviser status would have been required to be state registered by October 19, 2011.

However, an April 8, 2011 letter (cited in my article immediately below) from an associate SEC director indicates that the SEC is now expected to consider extending the date by which mid-sized advisers will be required to report their eligibility for SEC registration until the 1st quarter of 2012. Additionally, those no longer eligible for SEC registration would have a grace period giving them time to register with the appropriate state(s) before withdrawing their SEC registration.

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

Private equity and hedge funds with over $150 million in assets under mangagement were slated to be required to register with the SEC by July 21, 2011.

However, an April 8, 2011 letter from Robert. E. Plaze, an Associate Director of the SEC, stated that it was expected that SEC would consider extending the deadline for registration until the 1st quarter of 2012. Mr. Plaze also stated in his letter that the SEC will isue final rules regarding exemptions from registration for venture capital funds and funds with less than $150 million under management in advance of July 21, 2011.

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

April 04, 2011

A number of lawsuits, some in the form of class actions, have recently been brought against broker-dealers ("BD's") for allegedly failing to properly conduct due diligence on private placement securities. When a firm loses one of these cases, damages can be substantial and in some instances enough to bring down the entire firm.

Perhaps it is time to review BD due diligence obligations and specifically FINRA's (the acronymn stands for the Financial Industry Regulatory Authority) view of the same. In Regulatory Notice 10-22 FINRA reminded BD's of their obligation to conduct a reasonable investigation of the issuer and securities they recommend in private placement (Regulation D) offerings.

The Notice cited instances of BD fraud and sales practice abuse such as provision of private placement memoranda and sales materials to investors that contained inaccurate statements or omitted material information needed for investors to make informed investment decisions.

Noting that failure to conduct reasonable due diligence could be a violation of anti-fraud provisions of the securities laws[1] as well as FINRA rules[2], the Notice referred to the courts having found that the amount and nature of the investigation required depended, on among other factors, the role of the BD in the transaction, its knowledge of and relationship to the issuer, (a BD affiliated with an issuer has to ensure that its affiliation does not compromise its independence in its investigation) and the size and stability of the issuer. For example, a newer, smaller issuer, which would include many issuers in private placements , would require a more thorough investigation.

Also, the Notice pointed out that the presence of “red flags” [3] in an offering should alert a BD to conduct further inquiry. Interestingly enough, although acknowledging that private placement memoranda were not required for private placements to “accredited investors” in Rule 505 or 506 offerings under Regulation D, the Notice questioned, in view of the fact that such private placement memoranda were commonly used in Regulation D offerings, whether the absence of such a memorandum might be a red flag.

Many BD retain counsel or outside experts to assist the firm in due diligence. However, the Notice makes it dear that a BD needs to carefully screen the qualifications and competence of such persons, ensure that all gaps or omissions in such third party investigation are addressed by the BD, and that the BD itself is responsible to conduct such further investigation as a review of the counsel’s or expert’s report might indicate.

A BD which is only a member of a selling group or a syndicate may rely upon the due diligence of the syndicate manager if the BD has reason to believe that the syndicate manager has the needed expertise and absence of conflicts to conduct a proper investigation, and that in fact the syndicate manager did perform such inquiry. The BD should meet with the manager, obtain a description of the due diligence activities of the manager, and ask questions of the manager with regard to the manager’s independence and the thoroughness of the manager’s investigation. Also the BD maintains responsibility to conduct its own due diligence on issues not covered by the manager.

The Notice also reminded broker-dealers that securities offered in private placements had to meet the suitability requirements of NASD Rule 2310 and comply with FINRA and SEC advertising and suitability rules. Moreover, the Notice detailed the records a BD should keep to document that it undertook a reasonable investigation.

While noting that no single checklist would suffice for every due diligence investigation, the Notice did give the following list of practices that some firms have used to help them in carrying out their due diligence responsibilities:

A. Issuer and Management

Reasonable investigations of the issuer and its management concerning the issuer’s history and management’s background and qualifications to conduct the business might include:

Examining the issuer’s governing documents, including any charter, bylaws and partnership agreement, noting particularly the amount of its authorized stock and any restriction on its activities. If the issuer is a corporation, a BD might determine whether it has perpetual existence.

Examining historical financial statements of the issuer and its affiliates, with particular focus, if available, on financial statements that have been audited by an independent certified public accountant and auditor letters to management.

Looking for any trends indicated by the financial statements.

Inquiring about the business of affiliates of the issuer and the extent to which any cash needs or other expectations for the affiliate might affect the business prospects of the issuer.

Inquiring about internal audit controls of the issuer.

Contacting customers and suppliers regarding their dealing with the issuer.

Inquiring about past securities offerings by the issuer and the degree of their success while keeping in mind that simply because a certain product or sponsor historically met obligations to investors, there are no guarantees that it will continue to do so, particularly if the issuer has been dependent on continuously raising new capital. This inquiry could be especially important for any blind pool or blank-check offering.

Inquiring about pending litigation of the issuer or its affiliates.

Inquiring about previous or potential regulatory or disciplinary problems of the issuer. A BD might make a credit check of the issuer.

Making reasonable inquiries concerning the issuer’s management. A BD might inquire about such issues as the expertise of management for the issuer’s business and the extent to which management has changed or is expected to change. For example, a BD might inquire about any regulatory or disciplinary history on the part of management and any loans or other transactions between the issuer or its affiliates and members of management that might be inappropriate or might otherwise affect the issuer’s business.

Inquiring about the forms and amount of management compensation, who determines the compensation and the extent to which the forms of compensation could present serious conflicts of interest. A BD might make similar inquiries concerning the qualifications and integrity of any board of directors or similar body of the issuer.

Inquiring about the length of time that the issuer has been in business and whether the focus of its business is expected to change.

B. Issuer’s Business Prospects

Reasonable investigations of the issuer’s business prospects, and the relationship of those prospects to the proposed price of the securities being offered, might include:

Inquiring about the viability of any patent or other intellectual property rights held by the issuer.

Inquiring about the industry in which the issuer conducts its business, the prospects for that industry, any existing or potential regulatory restrictions on that business and the competitive position of the issuer.

Requesting any business plan, business model or other description of the business intentions of the issuer and its management and their expectations for the business, and analyzing management’s assumptions upon which any business forecast is based. A BD might test models with information from representative assets to validate projected returns, break-even points and similar information provided to investors.

Requesting financial models used to generate projections or targeted returns.

Maintaining in the BD’s files a summary of the analysis that was performed on financial models provided by the issuer that detail the results of any stress tests performed on the issuer’s assumptions and projections.

C. Issuer’s Assets

Reasonable investigations of the quality of the assets and facilities of the issuer might include:

Visiting and inspecting a sample of the issuer’s assets and facilities to determine whether the value of assets reflected in the financial statements is reasonable and that management’s assertions concerning the condition of the issuer’s physical plants and the adequacy of its equipment are accurate.

Carefully examining any geological, land use, engineering or other reports by third-party experts that may raise red flags.

Obtaining, with respect to energy development and exploration programs, expert opinions from engineers, geologists and others are necessary as a basis for determining the suitability of the investment prior to recommending the security to investors.

Nothing is this blog is intended to be or may be relied upon as specific legal advice. Securities and related laws are complex and facts are different from case to case. Competent counsel should be consulted. Views expressed by the author in this article are his own and not those of any other person.

[3] The Notice cited a federal case where the court held that the duty to investigate is greater “where promotional materials are in some way questionable, for example by promising unusually high returns”; the Notice citing another federal case also referred to inability to rely on audited financial statements where there were “red flags” that indicated the financial statements were inaccurate; also an issuer's refusal to provide information was cited as another red flag